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Does insurance belong in super?

The establishment of the compulsory Superannuation Guarantee was in recognition of the unaffordable nature of the pension system, given the demographic shift that the baby boomers would create in coming decades. It forms a major pillar in Australia’s retirement savings framework whereby retirement income is funded by:

  1. the safety net of the pension system
  2. superannuation savings including voluntary and compulsory contributions
  3. personal savings.

After only 20 years, Australia has created a savings pool that is the envy of the world.

Interestingly, there is nothing in the above which addresses insurance needs, yet life and TPD (total and permanent disability) insurance are playing an ever-increasing role in superannuation. There is little written about why insurance was included in the superannuation architecture, but one can envisage the logic went something like this:

  • superannuation is a compulsory system and every working Australian should have at least one account
  • there is an underinsurance problem in Australia
  • we can solve the underinsurance problem if we default insurance in super
  • if we try hard enough, we can make a link between life and TPD insurance and retirement income.

Insurance seems to be increasingly important in superannuation, whether it be the large increase in premiums in the last couple of years, or the entire section dedicated to insurance in the Super System Review recommendations (otherwise known as the Cooper Review). ASIC lists insurance as one of six key considerations in picking a super fund, while the acknowledgement of consideration of insurance is mandatory in accepting a super rollover form. For SMSF trustees, it is now mandatory to consider insurance as part of the SMSF’s investment strategy. Insurance is well and truly imbedded into the superannuation system.

Yet the question that does not seem to be asked is, “does insurance belong in super?”

The main objective of the super system is to alleviate the pressure on the age pension system. This gives us the ‘sole purpose test’ which ensures a super fund is maintained to provide benefits to its members upon their retirement (benefits can be released prior to retirement age, but these are only under special circumstances).

Contrary to the sole purpose test, life and TPD insurance provides protection primarily for the current day, whether for a member’s family in the event of death or the member themselves in the event of a permanent disability. The Cooper Review’s justification for this was that:

“Superannuation funds are generally structured towards financing a period of retirement after a long engagement in the workforce. Fortunately, that is the experience of most members. However, for a significant number of members each year, total and permanent disability (TPD) or premature death mean that they or their dependants need to call on their superannuation savings much earlier and for a longer period than they would have expected. Insurance plays a crucial role in allowing those needs to be met.”

This explanation is not a very convincing link but given the noble purpose outlined, it should not be an issue provided that it does not impact the functioning of the superannuation market.

And this is where things get interesting. Superannuation provides for a retirement outcome. The decision on which superannuation fund is the right fund for an individual is in itself a difficult one, considering fees, service quality, investment options, performance and trust in the institution. Insurance on the other hand provides protection for the current day. In selecting an insurance provider, an individual would consider the level of cover, premiums, service quality, policy exclusions and trust in the institution.

The problem with defaulting insurance in super is that it distorts the decision-making process.

For example, an individual may want to change super funds because they are not happy with the features and service levels of the incumbent fund; however their insurance offering is excellent. What decision does the individual make? Do they compromise their retirement outcome due to their present day insurance needs?

Conversely, a member’s superannuation fund may experience a large increase in insurance premiums. Does the member change super funds as a result, even if they are happy with all other aspects of their fund?

Both scenarios create difficult decisions for members and more importantly distract from what a superannuation decision should be based on, engaging with members on their desired retirement outcome.

From a super fund’s perspective, there is the time, effort and cost invested in managing insurance within the fund, whether negotiating a policy’s premium rates, managing data to support the group underwriting process or managing the claims process. All this distracts from the sole purpose of maintaining a superannuation fund for the purpose of providing benefits to its members upon their retirement.

In trying to solve an under-insurance issue, we have added cost and complexity to superannuation for both product providers and members. The further question is, does the social benefit outweigh the additional cost and complexity?

 

Christopher Sozou is Head of Wealth at Virgin Money.

19 Comments
Jacquie Jenkins
September 02, 2014

Life insurance in super has, and continues to be, a cost effective, efficient and affordable way to insure a large section of the population. Its more cost effective due to the size/scale of the group and the bulk discount insurers can provide. This is why its offered on an opt out basis. It also keeps a cap on the costs of government welfare disability payments.


The issue of insurance premiums eroding super balances is very topical and valid. As a result we'll see changes in the insurance products offered, increased claims management and increasing member awareness around monitoring and guarding against their super balances being eroded.

Tim
September 03, 2014

the notion that "insurance premiums are eroding my super balance" makes about as much sense as saying "my home and contents insurance premium is eroding my bank account".

The whingers can remove the insurance cover by ticking a few boxes on a form....but no, that is too difficult.

SMSF Trustee
September 02, 2014

Along with my fellow trustee (my wife), our SMSF recently made a small change to strategy. We use an admin system provided by one of Cuffelinks sponsor organisations and duly indicated the change to strategy so that it wouldn't be reporting we were out of line. The system required us to tick a box indicating that 'the insurance needs of all members were taken into account' in making the change. We also posted a note for file about our strategy meeting at which we agreed to the change.

The system generated an alternative meeting minute for us to sign that included the following:

It was NOTED that the insurance needs of members of the fund were considered as part of developing the investment strategy.
It was RESOLVED that the level of insurance cover provided for the members was appropriate at this time.

I wonder if most people managing an SMSF without using a system like this are aware that they need to document the insurance needs of members in this way.

Alun Stevens
September 02, 2014

I don't think it necessary to be lecturing trustees to think about the cost and quantum of cover. This implies that this is something they haven't thought of and that this is being neglected.

I think it is fair to say that trustees do in fact consider the type and level of insurance quite carefully and in fact did so even before it became mandatory under the Prudential Standards. We do a lot of insurance reviews and tenders (some underway right now) and I can't think of one where the dichotomy between providing an adequate level of benefit, but also not inappropriately eroding the retirement benefit was not considered.

I don't have a problem with Income Protection insurance within superannuation, although there is no reason why it can't be arranged outside. Many policies specifically make provision for the payment of the superannuation contribution that would have been paid had the beneficiary been working.

Dennis Barton
September 02, 2014

A good discussion, particularly Alun’s contribution. Not mentioned yet are opting out, which one can do in many funds, preserving insurability (early insurance avoids underwriting problems if one’s health deteriorates) and the cost advantages (declining somewhat as the experience deteriorates) of group cover over individual policies.

Andrew Weinmann
September 01, 2014

Insurance in super isn't new, either. The old defined benefit schemes had (and have) disability and death benefits built in, usually paying more than the resignation benefit accrued at the date of disability or death. Some schemes self insure for the extra liability, others don't.

So, taking insurance out of super would not be a return to some pre-SG utopia. It would be a radical departure.

Christopher Sozou
September 01, 2014

It is great to see so much engagement on this topic. The purpose of this article was to get people thinking about a topic which I have not seen debated but has been in my mind recently.

Rightly or wrongly I view things somewhat differently.

Superannuation is a retirement phase of life product. It encourages you to defer current consumption and save for retirement. In limited circumstances, generally in times of stress (financial or health), superannuation can be used for current day purposes however this is ancillary to the purpose of superannuation.

Insurance is a current phase of life product. It provides either lump sump or continuation of salary benefit for current day consumption. In some circumstances, the insurance benefit will be such that it sustains you into retirement (although I have not seen a default super offering of this nature).

I do not believe the link is a strong as some suggest for the reasons stated above and I see cost, compliance burden and member confusion that insurance in super creates everyday and question whether the social benefit outweighs this cost and complexity.

Ramani
September 01, 2014

Definitional or semantic, the scope of sole purpose test and its relevance is the broad theme that needs examination as the 20+ old system passes from adolescence to adulthood. Insurance evokes strong feelings for and against, but so do a host of other SPT-related topics: real business property exemption for SMSFs, ability to game the system for inheritance rather than intended member retirement, deliberate as distinct from inherently embedded gearing and its pesky cousin LRBA.

Other successful regimes (Singapore CPF, for instance) have widened the scope to broader life style issues such as housing. This has also been raised in Australia.

Given the taxpayer's financial and social need for a functional system, this debate is a must. We should include steps to mitigate some of the side-effects (such as in insurance, the proliferation of complaints to SCT) by simplifying the default product and making it easier for trustees to focus on their core role.

Matthew Griffith
September 01, 2014

I think it is healthy to ask the question and review the system from time to time. The answer I think is clear: Superannuation has always been occupation related. It therefore goes without saying that life, TPD and TTD insurance all belong in super for the simple reason that the benefit is a lump sum substitute for a salary no longer being earned that get's paid into the superannuation account and becomes unpreserved to allow the member or their beneficiaries to drawdown the benefit.

Stephen Corner
September 01, 2014

I think we are playing on semantics with this one. To borrow from Alun, insurance is the bridge that can be built anywhere from now until retirement for when the employment road goes into a sink-hole. I don't think anyone here is disagreeing that it is an important element in ensuring the optimal financial position possible for a person come retirement.
So given that insurance should be taken out, we need to look at how best to effect that. Just as the SG forced (a lot) of people who had not financially planned for the future to put money aware for their retirement, having insurance in super ensures that people who are not financially literate are covered for risk events. If a person does not have insurance and has to leave the workforce due to illness or an accident, they may need to draw on their superannuation (possibly with penalty tax rates) earlier than preservation age. So not having insurance can be said to cause their super to fail the sole purpose test.
Super is important and insurance is equally so. Where the deductions come from should be a matter for the accountant.

Jamie Forster
August 31, 2014

Hi Stephen

I agree with your comments and that it is a good question to raise.

I also think your comments regarding salary continuance are relevant and that some policies certainly do not meet the sole purpose test. The insurers have got a lot more strict about enforcing this since the new legislation introduced on 1 July this year.

However, the fact remains that SIS allows for a release of super in the event of a temporary disability and that the sole purpose test allows for insurance that meets this definition. I'm not necessarily saying I agree with it but just that is the situation at the moment.

That said, holding salary continuance in super can be a useful solution for some people who need this cover but who have difficulty meeting the premiums out of their cashflow.

Stephen Huppert
August 31, 2014

Jamie, the reason I suggest that this is a good question is that Trustees need to consider the role of insurance and the appropriate type of insurance for their members. I agree that the answer is not 'no insurance in superannuation' but Trustees should consider the proportion of their members contributions that are being used to by insurance cover. I know some Trustees are considering limiting this to, say, 10%. There is no correct answer but it needs to be considered.

I am curious as to how salary continuance insurance meets the sole purpose test. Wouldn't aged care health insurance be more relevant for superannuation? Again, no right answer but a discussion we need to have.

Jamie Forster
August 31, 2014

As with default investment selections, default insurance selections are necessarily flawed. Perhaps, similar to democracy, the default system is the worst system other than all the oth­er systems that have been tried and failed. Of course, unlike democracy an engaged member then has the ability to implement their own preferred choice.

By definition, a default choice must be made for a disengaged member. The decision then comes down to whether the default insurance decision is zero or some insurance. One solution to this is to base the level of cover on rules of thumb for members based on their stage of life which is typically best indicated by their age. So a member's default cover might increase as they get older to a certain point and then decrease from then on.

I don't for one moment suggest that insurance in super is the solution for every individual's needs or even the main solution for some individual's needs.

There have been some very good reasons put forward as to why superannuation is a natural part of the insurance solution.

As far as I can tell, the main reasons given for not having insurance in super is that some people are paying premiums on default cover that they do not need. I concede that is an issue, however I believe that the downside of this is less than the downside of not having cover.

Alex Dunnin
August 30, 2014

Another angle is using super funds to distribute (make available) insurance is not the same thing as the super fund having to hold a policy with the insurer.

Stephen Huppert
August 30, 2014

This is an important question. Just because insurance has always been part of superannuation is not a reason not to ask the question. Just because we believe that there is a role of insurance in superannuation doesn't mean we shouldn't have a debate on types of insurance and possible limits on insurance in superannuation.

Trustees need to consider amount and type of insurance that is appropriate for superannuation in general and their members in particular. We also need Australians to consider the amount and type of insurance they need and understand what their fund offers and what they will need to source individually. It is not reasonable that every Australians insurance needs are able to be met through superannuation.

Trustees need to understand the trade off between more generous insurance offerings (both levels of cover and types of cover) and the impact of higher premiums on retirement outcomes. In fact, there are a number of trustees having these discussions and considering limiting insurance so that, for example, premiums are no more than a certain percentage of contributions.

Ramani
August 29, 2014

The way to super hell, as with its astral sibling, is paved with good intention overtaken by time. Insurance in super fits this well.

Insurance needs tailoring to one's risk needs (as illustrated by comments above). Default, being necessarily average, is unlikely to provide a good fit, especially with passing time. Disengagement in super and disinterest in prospective insurable perils combine to make member involvement scarce.

Since the advent of compulsory and soft push super, funds have struggled with the right way to decide death and TPD claims, and have to fight their way in SCT and courts. For a mutual industry with little capital, this is often a drain on unwitting other members eating into their balances.

More recently, sustained under-pricing by insurers (loss leaders make sense only if there are profit followers) and the growing muscle of super tendering out group cover have caused a trend which if unchecked would portend insolvency: APRA would be distinctly unamused.

Stephen Huppert's work on the role of insurance in super, as these trends play out, is seminal reading, as is this article.

About time we move from the current fundamentalist notion that insurance in super is an unquestionable benefit. Triggered by our quest to save on tax (the 15% saving inside super) we have become complacent to its unseemly effects: avoidable disputes, ill-fitting products and consequences on anti-detriment payments.

With so many sexy topics competing for discussion space (tax concessions, contribution caps, FoFA confusion and SMSF mendacity), no wonder insurance ails from attention deficit. Time to reorder our priorities, and review.

Alun Stevens
August 29, 2014

Unfortunately the article is based on an incorrect premise. The main reason for pushing for SG was not specifically to save the drain on the Age Pension although it is sometimes described that way. The biggest issue at the time was that only a minority of Australians had super and that super was generally tied into company DB plans with poor transfer values. It was clear that the majority would reach retirement with virtually no savings and that this was undesirable not only because it would put pressure on the social security system including the Age Pension.

This is also why insurance is, and always has been, part of the superannuation system. Saving for retirement is fine, but what happens if the person can't work through to retirement? They not only can't work, they can't save until retirement. Insurance provides the self completion element to the system. If the person can work through to retirement, they can save. If they can't work through to retirement, insurance provides the funding that they otherwise would have been able to commit.

Put simply, there can't be a sound superannuation system without insurance. The real questions are how much and what sort.

Caron
August 29, 2014

When looking at my late teen/young adults' superannuation funds that are established with their part time jobs, I noted that the funds were quickly depleted by the payment for insurances. You could, by letter, opt out and we did.
Who benefits if my child dies? There are no dependents, there is no mortgage. While disability through accidents is a frightening, though rare, possibility, while not perfect, there are other mechanisms to care for a rehabilitating and disabled person.
If superannuation is for the sole purpose of building a savings pool for retirement the seemingly compulsory taking of superannuation funds out of young people's funds seems to work against the 'sole purpose' test. Actuaries could easily show that every $100 that stays in a super fund from the age of say 20, is worth many times that $100 entering that fund later in life.
So why hasn't this been addressed - it's easily done. How about insurance companies design a product young people could choose to buy if wanted outside of the superannuation environment that can easily and without loss be transferred into the super environment before the age of thirty if so chosen.
How many under twenty fives really need or want superannuation? It works against the sole purpose test of superannuation and it also would fall behind saving for mortgages, or paying HECs debts for most.
But who will champion this for young people?

Jamie Forster
August 29, 2014

A very interesting article and a question that was certainly worth asking.

However I don't agree with the author's conclusion or with the author's view of the Cooper Review's reasoning for having insurance in super. In my view the explanation was spot on. In particular, the TPD of a member is, in essence, retirement brought forward.

Just because you reach the age at which the legislation says you may access super doesn't mean that you will retire. Plenty of people work well beyond that and into their 70s and 80s.

Similarly, just because you are younger than the age at which the legislation says you may access super doesn't mean that you may not be forced into retirement. '

So, unless it is being suggested that total and permanent disability (as defined in SIS) should not be a condition of release then TPD very much forms part of funding an early retirement should it be necessary.

That is, if you accept that TPD should be a condition of release then it follows that a policy intended to fund the member in the event of a TDP should be able to be held by a super fund.

 

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